Appendix 4 Suggested answers to selected problem questions
Thus there is nothing inconsistent between reasonable treatment of customers
and the best interests of the shareholders.2.4 The separation theorem says that the investment should be undertaken if it gener-
ates wealth for the business. Doing this will make the shareholders more wealthy.
How the investment is financed is a separate matter and, under the assumptions
made by the separation theorem, unimportant. Either the dividend could be paid
and money borrowed (or raised from a share issue) to make the investment, or the
dividend not paid and the existing cash used to make the investment.2.5 According to the assumptions made by the separation theorem, any dividends paid
to a shareholder can be invested at the prevailing rate of interest. If the business has
to pay that same rate to borrow cash to finance an investment, the shareholder gains
an amount from lending that is equal to the shareholders’ share of the interest paid
on cash borrowed to make the investment.2.6 The most obvious reasons for this are:
lThe business, because it is better established in the financial market and because
it would be borrowing a relatively large amount, may well be able to borrow at
lower rates than could an individual shareholder borrowing a small amount.
lIn the context of the UK tax system, the interest payable would be tax deductible
to the business but not to an individual shareholder.3.1 A balance sheet is a list of assets and financial obligations of an organisation at a
specified point in time. The assets are typically shown at how much they cost when
they were acquired by the organisation (historic cost). Depreciating non-current
assets are normally shown at cost, less some proportion of that cost depending on
the anticipated useful life of the asset, and how much of that life has already expired.
Since assets are usually valued on the basis of their cost, the balance sheet does
not provide any reliable indication as to how much the organisation is worth, in
market value terms. Some assets may be overstated in the balance sheet, relative to
their current economic value, some may be understated, and some assets (for exam-
ple, goodwill), which have a current economic value, may not appear in the balance
sheet at all because they have no cost.3.2 The profit is the net increase in assets arising from trading activities. Net cash inflow
from operating activities is the increase in cash. The difference between them arises
from two broad factors:
lDepreciation of non-current assets, which is an expense deducted from profit but
which has no effect on cash flow.
lIncreases and decreases in inventories, trade receivables and trade payables, which each
have the effect of absorbing or releasing cash. Thus, for example, if inventories
increase over the period under consideration, this additional investment means
that the amount of increase in cash will be reduced.3.3 A strong balance sheet normally means that the business is in a healthy position as
regards the balance of assets and financial obligations. This usually refers to two
areas:
lWorking capital.Here the relationship between current assets, particularly the
more liquid of them, and current liabilities is the issue. Thus ratios such as the
current ratio and the acid test ratio would be fairly large in a strong balance sheet.Chapter 3
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